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Thursday, January 10, 2008

Have you heard about subprime crisis in U.S? Do you know what is it? Do you know why it happens? This article provides a very simple explanation of subprime crisis especially for those non-financial people or economist.

It was a very hot issue that has been discussed over the last year. I tried to search around the web to get more information about this subprime crisis in U.S. but all those explanations were too difficult for me to understand. So, this article is to simplify the explanation of subprime crisis which appears to be a very complex thing. I did this on my own research based on my understanding. You can verify whether my understanding is correct or not.

What is Subprime Mortgage?

First of all, we need to understand what subprime means. By dictionary, “Subprime” is an adjective relating to or for people with a poor credit rating. Simply says, if you never clear your credit card balance monthly, you have a poor credit rating. A poor credit rating people are disqualified to apply for conventional mortgage or loan application. They’re disqualified because they have higher risks that they are not able to make the loan payment due to their poor credit history. Bank is very clever. They come out a special type of loan to these poor credit rating people. This loan or mortgage is called “Subprime Mortgage” or “Subprime Loan”.

Why Banks Want Subprime Mortgage?

Why banks (subprime lenders) want to lend money to those who have bad credit history? They may not even able to payback the bank. But still, why they want to do that? Yes, you got it. It is all related to money. The banks are also greedy and they want to earn more. The main reason why the banks want to do this is they predict the value of the property will be going up. So they increase the mortgage interest rate (higher than the conventional loan) and they call it a subprime mortgage. They earn more with the higher mortgage interest rate and just in case the borrowers can’t continue the payment, they still can sell the houses with higher value due to the property appreciation.

To further reduce the risks and to get more loans (earn more money by loan interest), the banks repackage all mortgages into an investment product and sell it to financial institutions in all over the world (not just in U.S). This is now not only between banks and borrowers get involved in this subprime mortgage but also all the financial institutions around the world. You may ask why they want to invest in this high risk product (pool of subprime mortgage)? One reason, they believe that the property value will go up.

What happen to subprime borrowers?

They buy the house only for one reason which is expecting value of the houses to go up and they earn from the property appreciation. They can rent out their house with higher value or they can sell the house with higher value. All the debts they had previously can be easily paid off. Because house prices had increased so rapidly in the past few years, paying back the loan payment is not a problem at all. The borrowers also refinance their loan at more favourable terms due to they no longer have a bad credit rating history.

Can you see that? Everybody wins! Borrowers, banks and financial institutions are eating the same cheese happily and the cheese is “property appreciation”. Yummy, yummy!

When and Why Crisis Happens?

I think you should be able to guess it by now when the crisis will happen. Everybody enjoys the same cheese, if the cheese is gone, what happen? Crisis happens. It is that simple. When the house or property values drops, the cheese is gone. Everybody wins now becomes everybody loses!

When demand is more than supply (everyone wants to buy house), the property values went up like crazy. Until one day, when it becomes much more expensive to borrow, less people could afford to buy a house. As there were not as many buyers, the real estate market begin to cool down and house prices begin to fall.

When the house prices begin to fall, the subprime borrowers are going to suffer. Not only they’re not able to pay their existing debt, they are stuck having to pay a much larger mortgage payment. This causes many of these borrowers to not be able to make their house payment.

So for the financial institutions, they are going to lose their money that they invested because the borrower are not able to pay the loan payment. On the other hand, banks have a very big problem also because they rely on this these financial institutions to invest in the pool of mortgages investment product. Financial institutions no longer wants to invest and do not trust the bank anymore. If no wants want to buy them, where the banks get the money to offer the loans?

They bank also suffer from the lost for those borrowers who failed to make payment. As a result, the banks increase the mortgage interest rate to cover loses and hopes that borrowers (who afford to pay) can pay more. Sadly, the effect is opposite and this even makes the conditions worst. More and more borrowers failed to pay their monthly loan payment due to the interest rate increases. Crisis happens! Everyone suffers!

Conclusion

Subprime crisis happens because everyone predicts the property value will appreciate over time. The economy now is no longer as simple as in 30 years ago where we can predict the future with certain of accuracy. Future is getting harder and harder to be predicted for the coming years. What it next? It is really unknown.

Therefore the impact of this crisis is still has a lot of uncertainty. Will it causes another economy recession in U.S since 2000? Will this affect other countries? This is another huge topic to be discussed. Anyway, I hope this post is making sense and give you a little bit general idea on this subprime mortgage crisis in U.S.

To have more comprehensive of explanation (which I find it difficult to understand), you can refer to this article from wikipedia.

[Updated - 2 Feb 2010]P/S: I recently wrote about Understand Money as Debt Concept topic which could be one of root causes of this subprime crisis. You may want to read the article. Let me know if that is useful as it could be quite difficult to understand.

It was a okay explanation, but your grammar made some parts a bit hard to understand. Overall it was pretty good considering it was only basic, but your wording just needed to make a bit more sense. Good job :)

well the post was quite good..but i had 1 question...why does the cost of borrowing increases and the price of property falls..why does that happen if everyone wants to buy a house then the demand is more than the supply..isn't it? so ain't the price ought to go up? i mean if u had thrown a bit more light on this then i being a non-economics student could have understood well!

You’re right. I think you have a point. I’m not an economic student too. Let me try to explain in a simple form see if it makes sense. There is a scientific term for this phenomena. It is called “Bubble Burst”.

If the house price keeps going up and up again until certain limit will you still buy? Or there is no limit? Think about it. Let’s say the house value increases from $100K to $500K. Okay you probably still believe it will still go up. What about from $100K to $1 Million? Will you still buy? There is one point you will think that “It is just too expensive”. Once you stop buying and everyone does the same, demand will than less than supply, the house prices start dropping. When the house price is dropping, will you dare to buy? So if everyone does not dare to buy, then the house prices will be dropped dramatically.

Hopefully this is clear. This explains why it drops. This happens usually due to speculation for example. The actual price of the house is way below the market price. What you see the price in the market now is not the real one. The amount of supply & demand amount is also not really the real one. That is why crisis happen and no one really can predict when it will happen. The worlds is too complex, it is not just you and me. Therefore no one can really think the crisis will happen that soon and still enjoying the cheese.

Does my explanation make sense to you? I hope it does help. It is more like sharing and discussion purpose. Thanks for the question and comment.

Good effort dude but ur explanation was incorrect as it were the financial institutions who started the process of lending money to the subprine borrowers and not the banks.There were 4 players involved:1. Financial Institutions2. Sub prime Borrowers3. Banks4. Institutional Investors.

It was a very intertwined game from the financial institutions who manipulated the incomes of the subprime borrowers to get more money to lend to the subprime borrowers from the banks and in turn also to earn form securitisation of the asstes.For more details u can always mail me to mynkjindal1983@yahoo.co.inI will be happy to address ur queries.

i really dont understand such economic based topics but your explanation made this topic so very clear to me.i hardly had to put in effort understanding it due to your article...thank u soo much...can u let me know about some of your more articles?

that was awesome. am sick of being one of those eco students who didn't get the intricacies of sub-prime crises.after this read, all i can say is:'bring on the questions, ladies and gentleman'job very well done!

The poor credit rating refers to people who has bad debt. There is a credit rating specifically for US and Canada. That is called FICO Score, the higher value that you get, the better credit rating that you are. That means the bank can borrow you the money with lower risk (because the chances for you to pay back is high). So, the bank will charge you less interest if you have good credit score. On the other hand if you have bad or poor credit score (i.e. your FICO Score is low), the bank has higher risk to lend you the money. Thus, they will charge you higher interest rates. So technically speaking, poor credit rating refers to “low” credit rating.

I think the main reason why banks fail is they’re too greedy. Keep in mind that the bank earns more if they lend the money to a bad credit score person due to the higher interest rate. So now assuming the bank can only lend the money to 100 borrowers. What will the bank do? There are basically 2 approaches:

(1)Conservative approach(earn less with lower risk): Lend to 20 borrowers with poor credit score and 80 borrowers with good credit score.

(2)Aggressive approach(earn more with higher risk): Lend to 80 borrowers with poor credit score and 20 borrowers with good credit score.

So in this case, the banks took the aggressive approach. That's why you see that 80% of the US mortgages are actually issued to subprime borrowers. Bank failed when the housing bubble burst because these 80 borrowers cannot pay back at all.

I’m not sure if I answer your questions. Basically the bank intention is always want to be winner but it is not always the case. It is like a business, you can’t win all the time especially if you want to WIN BIG!

The role of credit rating agencies suppose to prevent this kind of crisis but this doesn't happen mainly due to the conflict of interest. E.g. They need to give better ratings in order to continue receiving service fees. Thus, they are being criticized badly. To me, everyone should be blamed as well.

I'm not really sure what long term effect is. To me, at least it tells me everything is possible although it seems to be impossible. In other words, everything is unpredictable. Thus in personal finance as usual, we need to take into whatever that is not possible.

Thanks. Will put a reminder to myself to research more on the Eurozone crisis as you mentioned because I don't know much detail information about it. :) I also interested in Australia economy and at least to study how long they can sustain and grow.

Hi champdog correct me if I am wrong. So the relationship between the banks and financial institutions was as follows - the banks lent money to people with bad credit. Then they took a bunch of these loans, put it in a box and sold the box to a financial institution where the institution would pay the bank money for the box which was equal to the value of those loans in the box.

So my question is what is the institution gaining here in terms of a reward for lending to the bank. Are they earning interest. Then that interest rate should be less than what the bank gets as interest for what it has lent to the people with bad credit. Otherwise what is that bank gaining here? Am I right? Or it would take the money that it gets from the institution and relend it to other people with bad credit at an interest rate which is higher than the interest rate that the institution is charging the bank?

At high level, it was restructured as an investment products and sold it to financial institution. The financial institutions earn based on the return of these investment products.

You don't look at just one person. You look at the entire population. The whole point of repackage the products is to gain more customers to even earn more even thought it seems to gain less if you just merely looking at one customer. It is the quantity that makes them earn more.

I hope it makes senses. I almost forget everything about this already since it has been here quite some time.

Champ! I guess you have posted this explanation in 2008. Its 2015 today and beleive me this is still a wonderful explanation one can find in Google. I enjoyed this post though I was not able to understand properly the meaning of "repackage" business between banks & financial institutions. Hope you will explain it for me!

About the "repackage", as far as I understand, the bank basically sells it with a different financial product (e.g. bond) but this product is backed by the mortgage. I"m not completely sure whether is stated clearly to consumer in this new product or some thing that gets hidden because I haven't seen that kind of product/investment myself.

You know what, maybe is something like mutual fund? It repackage the stock and sell it as fund? Something similar. Anyway, don't completely trust what I said here because I'm not in the financial background. The term that I"m using most likely is wrong in the financial world. :)